Big Macs, Price Differentials, and Single Currency Areas

I fortuitously came across this while looking at something else:

What does the Big Mac say about Euro Area adjustment?

The Big Mac Index offers some quick insights into the state of currencies around the globe by comparing the price of Big Macs across countries. Of course, the Big Mac index was never intended as a precise gauge of currency misalignment, as the Economist has just reminded us in its latest update. According to them, it is just about making PPP and other difficult exchange rate concepts more digestible.

Well, in the euro area, we have the euro to be able to simply compare prices across the euro area. So how have Burger prices moved recently? Are prices in the euro area adjusting? Should we be pessimists or optimists on the adjustment challenge in the euro area? Since July 2011, the Economist has also been collecting the individual prices of Big Macs in major euro area countries...

Forex Fallacy

[This post is loooong. For those without patience, you can skip to the end without missing too much]

Tong Kooi Ong talks forex policy and promptly makes a meal of it:

How the middle class is subsidizing the Corporate Elites and why it has to stop

There is a feeling that Malaysia’s middle class are generally not a happy lot. Many moan about the rising cost of living, education and healthcare, their relatively low wages and rising debt as they borrow more to buy homes and cars…

…A major problem lies in the weak ringgit, which results in different purchasing power for the two “middle classes”…

Big Macs Again

*Sigh*

The Economist states upfront (with tongue firmly in cheek) that the Big Mac Index is "a lighthearted guide to valuing currencies" and "It is arguably the world's most accurate financial indicator to be based on a fast-food item."

The joke here is that it's the only financial indicator based on a fast food item.

The Star however apparently takes this seriously:

"According to the latest Big Mac Index, arguably the world’s most accurate financial indicator to be based on a popular burger, most Asian currencies are undervalued against the US dollar.

The ringgit is undervalued by 47% against the greenback, which was at the same level as the Thai baht.

Only Hong Kong (52%) and China (49%) were lower than Malaysia and Thailand among Asian countries."

I've ruminated on this subject before, and I'm not inclined to go through it again - but PPP-based exchange rate measures are simply not an empirically valid way to evaluate exchange rate levels or movements.

Burgernomics: Where's The Beef?

I was going to give this article a pass, but I had a little epiphany over the weekend that makes it worthwhile commenting on - not so much the article itself, but rather the example Tan Sri Lin See Yan makes of The Economist's Big Mac Index (here and here for the latest readings).

The Big Mac Index was based on a simple idea: since the Big Mac is relatively homogeneous (same ingredients, and almost the same in terms of other inputs), differences in pricing across countries should illustrate differences in purchasing power, and thus gives a clue as to the relative strength or weakness of exchange rates.

For example, the average USD price of the Big Mac is $3.57 while the average EUR price is €3.31 as at July 13th, which gives an implied USDEUR exchange rate of USD1.08. Comparing this to the actual USDEUR exchange rate of USD1.39, according to this measure the EUR is 29% overvalued against the USD.

If we take Malaysia as an example instead, with a local price of RM6.77 we get an implied-PPP exchange rate of RM1.896 compared to the actual of RM3.60, giving an undervaluation of 47%. If you look at most East Asian countries, you'll find a greater or lesser degree of undervaluation.

This type of analysis has therefore tended to confirm the stylised notion that East Asian economies are currency manipulators, and have kept their currencies cheap in relation to the USD to boost their export-growth models. I won't delve into more formal proofs (and dis-proofs) of this notion, but rather go into the potential hazards of relying on the Big Mac index as a PPP measure.

The standard critique is that Big Macs incorporate local inputs, which are generally composed of non-tradables (land, labour, localised taxes etc). I'd also add the potential for price differentiation from local supplies of tradables, particularly the ingredients themselves - beef, bread, vegetables etc, although the sauce as I understand it is a McDonalds monopoly.

This could explain much of the gross difference between countries, if you've followed my arguments based on the tradables/non-tradables model of exchange rate determination. Also, The Economist themselves warn that the Index should only be relied upon when comparing economies with similar income levels, a finding that is also derived from the same model - high-income countries have higher price levels, and would therefore have stronger currencies in relation to lower-income economies. Looking at the index, we do indeed find developing economies in general having derived-PPP levels lower than that of advanced economies.

The epiphany I was talking about earlier focused on something quite different, which could also strengthen the argument against a Big Mac Index as a PPP measure. When I was a student in London in the late 1980s, I was struck by the fact that Coca-Cola and many other global food and beverage brands had very similar prices to Malaysia's (admission: I'm a Coke addict) - on the face of it, this would imply the intuition behind the Big Mac Index was correct.

But looking at McDonalds' menu prices a different story emerged: Big Macs were indeed more expensive in the UK (and not just in London). Here's the kicker. While Big Macs were more expensive, Filet o'Fish were actually cheaper in the UK than in KL, on par with the humble Hamburger.

What that suggests to me are a few additional economic explanations, over and above the conventional critique:

1. The difference in prices between low-income and high-income economies can also be attributed to differences in the ability to purchase higher-protein diets. As countries shift from low-income to high-income, the protein intake of the population increases raising demand (and prices) for beef.

2. Differences in prices can also be attributed to consumer preferences for different types of protein. Honestly, how often do you see Asians eating beef as compared to chicken, fish or pork?

3. As a corollary to the above, access to alternative supplies of protein (for instance, access to the seas) would also impact beef demand.

Just as important as these factors are that Big Macs are not tradable - there's no price arbitration across borders because Big Macs are a perishable good, unlike for instance a can of Coke. Also, McDonalds is a multi-national corporation with a globally-recognisable brand. To me that suggests that it also likely practices price differentiation across markets, which is a characteristic of monopolies.

So there are quite a few more factors involved than just the conventional economic explanations for differences in purchasing power based on the Big Mac Index, and hence implied-PPP evaluations of exchange rates. A Filet O'Fish Index for instance could paint a very different picture of PPP between East and West.

Proving all these formally might take some doing, but I think I'm going to make a stab at it. It'd make for a decent publishable paper.

Exchange Rate Policy 1: Concepts

If it seems I’ve taken a break from blogging, it’s because I’ve been hard at work reconstructing my MYR exchange rate indexes. Since I’m still in the midst of refining them, this post should serve as a holdover until that’s done.

Nothing in economics is quite so confusing as exchange rates. The problem is that exchange rates are in essence relative prices, not absolute prices, and because in a world of multiple exchange rate regimes, making sense of exchange rate movements can be complicated. For instance the chart below shows the cumulative movements of the Ringgit against the G3 currencies since 2000 (2000=100):



Relative to the start date, Ringgit (MYR) is 6.9% stronger against Dollar (USD), 9.5% weaker against Yen (JPY), and 26.9% weaker against the Euro (EUR). Can we therefore say that the Ringgit is generally weaker or stronger? More to the point, what are the implications for policy and trade? At what stage should authorities decide that a currency is overvalued or undervalued enough to merit intervention? These and other questions will be the topic of this series of posts I’m embarking on.

The most intuitive and attractive concept of exchange rates is the theory of purchasing power parity, or PPP. In its strong form, PPP states that the same good should have the same price everywhere (aka The Law of One Price). Therefore the exchange rate of any two currencies should equate this price in local currency terms. For example if a Big Mac is RM8 in Malaysia, and US$2 in the USA, then the PPP exchange rate should be US$0.25 if we use MYR as the base and RM4.00 if we use USD as the base. If PPP is true, and the actual exchange rate is RM3.80, then we could consider the MYR as being 5% overvalued against the USD.

Unfortunately, empirical evidence for strong form PPP is patchy even over periods of hundreds of years. There is better evidence for weak-form PPP, where prices differ but the difference is constant. Even here, the proof is not absolute as exchange rates appear to deviate from the PPP predicted value for extended periods. The last 60 years has seen a lot of effort to decipher how this can be, given the importance of the exchange rate to international trade and the balance of payments.

One notion, called the Balassa-Samuelson effect, suggests that only tradable goods face price arbitrage in international markets and PPP should hold for these goods, but not for non-tradable goods and non-tradable components such as tax structures, property rentals, and so on. This effect should be particularly strong in services, which by definition are difficult to trade (imagine the relative value of the haircut for instance). The general effect of a strong non-tradable sector is an appreciation of the exchange rate.

Another school of thought focused purely on monetary effects and the impact of real interest rate differentials, called the concept of uncovered interest parity. The idea is that capital flows to where the real yield is highest, which in turn moves the exchange rate to equate the relative differences. Since investors view countries as having different risk profiles, a risk premium can also affect the exchange rate, which is the concept of covered interest rate parity. Inflation should also have an impact, as it is a measure of the relative supply of each currency – the higher the relative inflation rate, the more a currency is expected to depreciate.

The problem with these and other theories is that, taken in isolation, none do a good job of explaining exchange rate movements in the floating rate period (1972 onwards). The best statistical model of short term exchange rate movements is and remains the random walk, which in statistical notation is:

X(t) = X(t-1) + ε

Notice that this differs substantially from a simple regression model in that there is no intercept and no slope to the equation. What the random walk model states is that the best predictor of tomorrow’s market price is today’s price!

So what is a poor central banker to do? What finally made sense, at least in identifying medium to long term movements of the exchange rates, were structural models which put a lot of these concepts together. In real life therefore, it’s a combination of factors that influence the exchange rate, not one or two. But before models like these can be used, we have to figure out how to actually arrive at a single view of a currency rather than the multiplicity of rates that any currency is subject to, which will be the subject of the next post.